Equity line and Drawdown in Social Trading
We have seen the positive and negative characteristics of each Signal Provider’s category.
Now we just have to discover the two pillars, the two main components, those we will always analyze first whenever we will approach a Signal Provider.
We’re talking about the Equity Line and the Drawdown.
These two figures will be the first great divide between “interesting” and “to be discarded“. Your question at this point could be: “But, if they are the 2 main elements, the ones to start with, why do you speak about them only after the other parameters?“.
Here is why. As we have found through various feedback, many people make the mistake of relying solely on a rough analysis of these two elements, avoiding to go deeper in the analysis of what we saw in Chapter 6, or, even worse, not being even aware of it.
Equity Line and Drawdown are the two basic elements but, for the avoidance of doubt, they are not enough to make a good choice. These are the two essential elements to start, but, after the analysis, you absolutely have to analyze all the others. Otherwise, the possibilities of following a risky Signal Provider grow a lot.
In chapter 6, 7 and 8 we’ve clarified what are the elements which you must consider every once in a Signal Provider, now we’re going to see the two that will help you decide which among the thousands of traders to analyze further.
The Equity Line is a graphical representation of the Signal Provider’s account balance.
The chart that represents an Equity Line has, on the ordinate axis, the account balance, and, on the abscissa axis, the time, or the serial number of performed operations. The combination of the various points creates a line that represents the evolution of the balance, and it’s called precisely Equity Line.
We can make the first big division between:
- the Equity Line that show the trend for each trade
- the Equity lines that shows the daily performance, that is the final balance of what has been done during a trading day.
With the latter we might find times when the Equity Line is flat. This is because if the Signal Provider makes no operation during that time, the line will mark precisely the same constant value corresponding to the last balance. In the first case, instead, we can never find flat periods, because it doesn’t take into account the passage of time, but only the trade’s earnings or losses when it actually get closed.
Another division we might do is between:
- the Equity Line that shows the balance trend only for closed positions
- the Equity Line that also include the open positions movements.
For the Equity with only closed positions, in the case of daily progression, it will be clearly a balance formed by the sum of only the transactions closed during the day. These equities are the classic and the most famous ones, and they are very useful in understanding certain types of behavior of Signal Providers.
However, an untrained eye may sometimes misinterpret this kind of classical Equity Line. To explain better, if I close an operation, but I have other 10 open positions on the account, my balance situation could be very different than the one shown by an equity line with closed-positions only.
To give a practical example, let’s think about that who almost never closes a losing operations (the famous martingale). His classic Equity Line could be perfect and always climbing, since he closes his trades only when they are in profit or, if added together, they are at break even. In fact, the trader could have at the same time many other trades open at a loss, but the classical Equity Line would show only the “+10 pips” of the day, while it would now show the “-1000 pips of open positions.”
That’s why there are other types of Equity Line, which in addition to the balance of the closed positions only, they integrate within them also the real balance values, in view of all the open positions. There may be various types, such as Equity Line that includes only the open positions at a loss, or that include also those in profit.
The key thing when you look at an Equity Line is to know according to what criteria it has been designed, in order to have a clear view of the data you are looking at being able to make the right considerations.
The complementary element to the Equity Line, which extends the analysis opportunities, is the drawdown.
In simple terms, the drawdown represents the losses of a trading asset, or rather, the level of losses incurred before returning to profit.
Looking at a normal Equity Line, which has ascent moments and descent moments, the drawdown are all those descents that have occurred and that have been followed by new ascents, with new highs in the profit balance.
“How many losses the trader had to bear before being able to generate new maximum of profit on his account?“
This is the question to which the Drawdown responds accurately.
The drawdown can be expressed in two ways:
- we can consider the losses in absolute terms, such as money or pips
- we can consider it in terms of percentage.
The percentages help us with the analysis of the effective capacity of the Signal Provider’s trading strategy, while the absolute values, of money or pips, will help us mainly in the construction of our portfolio. Both factors, in any event, concur to support the decisions about money management, as we shall see in particular in the next lesson.
In our view the percentage Drawdown must always be calculated in two ways, or better said, taking two different references. Once you’ve identified a drawdown, you can calculate what is the percentage amount both using the total accumulated profits, both using the amount of profits achieved just before the Drawdown itself began. Both values are very important, and can describe this aspect of the trader’s performance from two different angles.
Percentages help us to observe the drawdown from another interesting point of view. If a Signal Provider loses 50% of his pips, in order to return at least to break even, he will not have to produce a new performance of just the 50%, but rather of the 100%. Yes because, if he loses 50%, he has halved his gains, therefore he has half the capital. To make sure that half will come back to being a whole, he will have to double it, in other terms, to do a performance of the 100%. We must therefore always be careful, because the higher the drawdown, the more difficult is to recover the profits.
As we have seen for the Equity Line, also the drawdown can be calculated and expressed in different ways, depending on what is considered, if only the closed positions, or if there are also the still-open positions.
The classical Drawdown in based on the classical Equity Line losses, caused by the closed and accounted operations only, while the one that include the open position too calculates how much the balance actually dropped in terms of capital, against all open positions.
Both these ways can give indications but as you can image, the main interest must be given to the Drawdown that include the open positions, because in this way we can actually observe the risks that have been susteined. Each operation, before being closed, oscillates. To calculate the possible risks I need to know how deep the downwards oscillation was, and then to know how deep the downward oscillation of the whole account was, considering the sum of all the trades open at any given time or day.
Beyond all the ways in which it can be represented, the value that interests us the most is the Max Drawdown, ie the maximum capital reduction before returning to create a new profit high in the balance.
Other values that may be useful are also the Average Drawdown and the Drawdown frequency, that is how often they occur.
Equity Line, Drawdown and all the other elements of analysis we have seen so far, when combined intelligently they concur to help the follower investor in his decisions about how to handle his money allocated in his portfolio, namely, about his Money Management.
In the next lesson we’ll make the following question.
“Given all these premises and these characteristics of the Signal Provider I have chosen, how can I best use my money to get the biggest possible returns?“.